The silver lining in rising interest rates

The RBI hiked the repo rate (by 0.5%) and the CRR (by 0.25%) yesterday.

For those who might not know, simply put, the repo rate is the short-term interest rate at which the RBI lends to banks. The Cash Reserve Ratio (CRR) is the percentage of bank deposits that the bank have to maintain in cash.

A higher CRR means less money available for lending and hence lesser money in the economy. A higher interest rate means lower demand for credit. Both measures are meant to contain demand and hence bring down inflation.

The RBI move appeared to have surprised most market watchers. After all, the argument went, the RBI has very recently raised repo rates and the CRR, the impact of which would be felt in some time to come. So most people thought that the RBI would wait and watch before it decides what to do next.

I wonder why people were surprised. Inflation was clearly much above the RBI's comfort zone, having reached 13 year highs. Credit growth was still above RBI objectives. After the UPA won the confidence vote in the parliament, its focus would have clearly been on killing inflation. Those who follow the current RBI governor, Dr. Reddy, would have known how he operates. So a rate hike and a CRR hike was to be expected...and I think it will continue for a while unless something changes drastically that brings down inflation.

So less money and higher interest rates will have an impact on the economy. Growth is likely to slow down further, especially after 5 years of fantastic growth rates, as the tightening measures come through. Corporate earnings growths would also come down as will their stock prices. Not good news if you are an equity investor.

But there is a silver lining in all these rate hikes. Continuing interest rate hikes will make stock valuations very cheap sometime down the road. At some point, inflation will (hopefully) turn around and head down. Interest rates will also head down concomittantly. And that would provide a fillip to the stock markets. So, patient investors can wait for stocks to become really cheap to buy.

A similar process happened in USA in the early 1980s. Inflation went up to as high at 12% in the USA and the economy was hurting. It was the then Federal Reserve Governor (equivalent to our RBI governor), Paul Volker, who kept raising interest rates and brought down inflation (which was followed by drop in interest rates). What ensued was a 18 year mega bull market (because of many other factors as well) in the USA till the 2000 technology bubble.

So wait patiently and watch for stocks to become cheap again...

Is this reform?

The UPA government survived the vote of confidence in the Lok Sabha

Hopes have been raised that there would now be more reforms since the left parties no longer can hobble the government.

So the stock markets rallied (maybe) on the back of such hopes.

Business channels have been discussing whether foreign ownership in Indian insurance companies will now be increased to 49%.
Or whether voting reforms or foreign stake increase reforms in Indian banks will go through.

What is the reform in this?

What reform occurs if foreign insurance companies own 49% stake rather than 26%?
What enhanced processes and knowledge does a 49% stake bring in that a 26% stake does not bring in?
Is the additional capital not available in India?

And what about banking reform?
We all are witnessing how foreign banks took unmanageable risks and lost billions of dollars in the USA and continue to lose more.
We are witnessing how there are now bank failures coming through in the developed world.
Are foreign banks really better than Indian banks?

We do need reform, real reform.
Allow public sector banks the ability to compete with private banks in all matters.
Give them total autonomy to run their operations
Reform the compensation structure to attract talent
Allow them to hire and fire depending upon market conditions
We need much more...

We need reform in oil PSUs
We need reform in LIC and GIC and other government isurance companies
We need reform in power

We need real reform, quickly.
Not just token measures that give, at best, marginal benefits...